Balance Sheet Time Bombs

In Subprime Crisis, the Worst Is Yet to Come

By Beat Balzli and Frank Hornig

Part 2: Foolhardiness and Greed

But as complex as today's banking transactions are, the motives behind key players' actions are as simple as ever: foolhardiness and greed.

Take Stan O'Neal, for example. As chairman of Merrill Lynch, he pushed the company into increasingly risky real estate deals. Highly profitable in the short term, these deals earned O'Neal handsome bonuses. The fact that the entire model stood on shaky ground was water off a duck's back to O'Neal, who left the company with $162 million in severance pay.

To meet their profit goals, banking executives and their brokers had repeatedly delayed performing risk assessments of their financial instruments. "What would happen if Boeing Co. or Johnson & Johnson rolled out products with similar defect rates?" the Wall Street Journal asked rhetorically. The subprime crisis, the paper writes, acts as "a vital portal onto Wall Street, helping us understand just how upside-down the place has become."

In addition, the banks' boards of directors, blinded by the celebrity status of their senior executives, neglected to draft recruitment scenarios for top-level positions. The consequences of their neglect are now coming home to roost, as they face a limited selection of qualified candidates. The few remaining prospects, like Deutsche Bank Chairman Josef Ackermann, are suddenly in high demand.

Other US banks are also feeling the pinch. Morgan Stanley and Wachovia reported write-offs of $3.7 billion and $1.1 billion, respectively -- and those were only the numbers being reported late last week.

While Wall Street brokers are worried about their usually lavish Christmas bonuses, analysts at market research company CreditSights are busy calculating expected losses for the fourth quarter. Their predictions include a loss of $5.1 billion at Goldman Sachs, $3.9 billion at Lehman Brothers and $3.2 billion at Bear Stearns, whose CEO, James Cayne, has also faced heavy criticism. Trouble is also brewing at British bank Barclays.

Meanwhile Germany has by no means remained untouched by the fiasco. Despite posting substantial write-offs, Deutsche Bank, Commerzbank and Hypo Real Estate managed to report earnings growth in the last quarter. Nevertheless, this has by no means eliminated the uncertainty.

Only after their annual reports have been audited will "they all be able to breathe easier," says a risk management expert. "In other words, all kinds of things can reappear in the last quarter." According to the risk management expert, so far the Germans have taken a less hard line in their assessments than the Americans or Swiss banks like UBS. Does this mean that it's all just a question of valuation?

The valuation of complex credit products, for which there are currently almost no market prices, is a hotly debated issue among bankers, auditors and industry groups. Neither the German Federal Financial Supervisory Authority (BaFin) nor the Institute of Public Auditors in Germany (IDW) has offered clear guidelines. The resulting vacuum creates the temptation to doctor the numbers.

Fraudulent labeling is a hotly discussed issue at the moment, especially among Germany's state-backed banks, which are currently revising their accounting rules. Under the proposed new rules, the types of assets banks used to acquire purely for trading purposes, to earn a quick euro, so to speak, could now be declared as a long-term capital investment. The advantage of this approach is it would allow painful market losses in trading positions to be posted directly to the profit and loss statement. Securities held to maturity, however, would not have to be valued at current market prices, but instead at their acquisition prices. It's the perfect recipe for concocting an accounting fairy tale.